Taxes on dividends are going up: the federal government is phasing in a new dividend tax credit regime between now and 2012 that will see those credits reduced. The result will be an overall increase in dividend taxes.

Not all provinces are making comparable changes. Combined federal and provincial tax rates on dividends for investors in the top tax bracket now vary widely — from a low of 16% in Alberta to a high of almost 30% in Quebec.

Tax practitioners agree that the wide variation is unlikely to change. Provinces like their autonomy, says Gena Katz, executive director with accounting firm Ernst & Young LLP in Toronto.

In fact, she says, after 2011, based on current legislation at the provincial level, combined federal and provincial tax rates on dividends for investors in the top tax bracket may reach as high as almost 21% in Alberta and 34% in Nova Scotia. (See “Top marginal eligible dividend rates” table, lower right.)

But 2009 may be the best year for individual investors to receive eligible dividends, Katz suggests, before dividend tax rates start going up.

Vern Krishna, a law professor with the University of Ottawa and tax counsel with law firmBorden Ladner & Gervais LLP in Ottawa, says provinces apply different tax rates because they have different revenue requirements and different tax policies.

As well, he suggests, by doing nothing: “A province can put an effective tax increase through the back door.” That’s the practical effect when the feds lower tax rates but the provinces do nothing, effectively leaving their own higher rates in place.

Krishna also suggests there may be further changes associated with elections — both federal and provincial. “With Canada’s aging population,” he says, “dividends will become increasingly important because an aging population depends on retirement income from stocks and bonds. This could result in more pressure from the public to reduce tax rates on dividends.”

Either way, says Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management in Toronto, dividends are still attractive for the average investor — certainly more attractive than interest income.

“But, depending on the province,” he says, “dividends may be less attractive than capital gains, going forward.”

Advisors need to look at the rates carefully, says Golombek, and discuss with their clients — in the context of their whole portfolio — what percentage is dividend-based and how their net after-tax return will be affected by rates prevailing in their province.

Golombek says taxation of dividends is based on the theory of integration, which is used to avoid double taxation of corporate profits.

Under this model, it is assumed the corporation paying the dividend has already paid taxes on its profits. Dividend income received by an investor is “grossed up” to approximate the total amount of pretax income the corporation is presumed to have earned.

The investor’s dividend income is then subject to a dividend tax credit, which effectively offsets the taxes the corporation is presumed to have paid. Based on this theory, Golombek notes, when corporate tax rates fall, both the gross-up and the dividend tax credit should also drop.

This is exactly what is happening at the federal level, at which corporate tax rates — currently 19.5% — are scheduled to drop to 15% by 2012.

Heather Evans, tax partner with Deloitte & Touche LLP in Toronto, explains that the revised dividend tax credit schedule, introduced in the 2008 federal budget, will see the gross-up percentage for eligible dividends drop to 44% in 2010, 41% in 2011, and 38% in 2012, from 45% in 2008 and 2009.

These gross-up decreases, says Evans, will be accompanied by changes in the dividend tax credit rate, which will drop from 11/18 of the gross-up amount in 2009, to 10/17 in 2010, to 13/23 in 2011, and ultimately to 6/11 in 2012.

Golombek says that the overhaul of the dividend tax regime in Canada, introduced in 2006 with the objective of levelling the playing field between investors receiving income from income trusts and those receiving dividend income (see page B6), introduced a system of “eligible” and “non-eligible” dividends.

Only eligible dividends — defined as those paid to Canadian residents by Canadian public companies and Canadian-controlled private corporations out of income taxed at the federal general corporate rate — are eligible for the lower tax rate. Most investors in the market will be receiving “eligible” dividends, Evans notes.

@page_break@So, why do tax rates on dividends seem to be going up? According to Golombek, the theory of integration assumes corporations will increase their cash dividends by the amount of corporate taxes saved; and provinces will also adjust their dividend tax rates. Neither of these assumptions, he adds, is “a sure thing.”

Golombek explains that the gross-up and credit system also makes certain theoretical assumptions based on provincial tax rates and their relationship to federal rates. “If these assumptions are not true [because provinces fail to act as anticipated],” he says, “there will be wide variations in rates.”

As well, Evans says, although the provinces are making changes to their dividend tax regimes, most are phasing in changes over time periods that don’t necessarily match. This may account for some of the current wide variation among provinces.

Tax rates on non-eligible dividends remain much higher and also vary widely by province. (See table top left.) According to Jason Safar, partner in the Mississauga, Ont., office of PricewaterhouseCoopers LLP, the new system will affect the way in which small-business owners decide how they take money out of their companies and also make the decision much more complicated.

Canadian private corporations are eligible for the small-business deduction, he notes. To the extent they have income taxed at the small-business rate, this income can only be distributed as a “non-eligible” dividend, Safar says. Only income taxed at the top corporate rate can be paid out as an “eligible” dividend.

Cautions Golombek: “Small-business owners need to rethink the whole salary versus dividend mix, and should run their numbers again every year over the next few years.”

Adds Evans: “The old assumptions about extracting money from the corporation no longer necessarily hold true.

“Business owners will need to do a more considered analysis,” she adds, “with reference to the province in which the individual owner resides, the type of business and the year — given the phase-in of changes over the next few years.”

Safar believes the small-business owner should formulate a compensation plan at the beginning of the year instead of waiting until year’s end to decide what amount to take out in bonus, salary or dividends. “There’s no longer any rule of thumb that can be applied,” he says. IE